Drafting Shareholder Agreements for Closely-Held C and S Corporations

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1 0001 VERSACOMP (4.2 ) COMPOSE2 (4.33) 04/22/02 (12:58) J:\VRS\DAT\00500\18.GML --- r500.sty --CTP READY-- v2.2 4/ POST 1 CHAPTER 18 Drafting Shareholder Agreements for Closely-Held C and S Corporations STEPHEN R. LOONEY Dean, Mead, Egerton, Bloodworth, Capouano & Bozarth, P.A., Orlando, Florida. Mr. Looney provides representation in the areas of tax, corporate, partnership, business and health care law, and in matters involving estate planning, with an emphasis in entity formations, acquisitions, dispositions, redemptions, liquidations and reorganizations. His clients include closely-held businesses, with an emphasis in medical and other professional practices Mr. Looney actively participates in the Tax Section of the American Bar Association, and is currently serving as the chair of the S Corporations Committee. Mr. Looney co-authors the Current Developments column for the Business Entities journal published by Warren, Gorham & Lamont, and also serves on the Board of Advisors and Department Heads to the Business Entities journal. Mr. Looney previously served on the Board of Advisors and Contributors to the Journal of S Corporation Taxation, and also served as a Recent Developments columnist for the Journal of S Corporation Taxation for a number of years. Additionally, Mr. Looney previously served as the S corporations columnist for the Journal of Partnership Taxation. Mr. Looney writes and speaks extensively on a nationwide basis on a variety of tax subjects. His articles have appeared in a number of professional publications, including the Journal of Taxation, The Tax Lawyer, the Journal of S Corporation Taxation, the Journal of Partnership Taxation, the Journal of Corporate Taxation and the Business Entities journal. Mr. Looney is a Board Certified tax lawyer. He is a member of the Florida Bar Association, the State Bar of Texas and the Missouri Bar Association. He also has his CPA Certificate, and is a member of the Missouri Society of CPAs. RONALD A. LEVITT Ronald A. Levitt is a partner in the Birmingham, Alabama law firm, Walston, Wells, Anderson & Bains, LLP, where he concentrates his practice in tax law, corporate law, business planning, estate planning and health care law, particularly for physician practices and closely held and family owned businesses. Mr. Levitt actively participates in the American Bar Association Section of Taxation, where he is currently serving as Vice-Chair of the S Corporations Committee. He has also served as Chair of the Alabama State Bar s Taxation Section and currently is an Adjunct Professor of Law for Cumberland School of Law teaching Partnership Taxation. Mr. Levitt writes and speaks extensively on a variety of tax subjects and has been published in The Journal of S Corporation Taxation. Mr. Levitt received a B.S. degree cum laude (in Marketing and Business Administration), an M.B.A. and a J.D. degree from the University of Alabama., where he served as Editor-in-Chief of the American Journal of Tax Policy and he received his LLM in Taxation from the University of Florida. 18 1

3 0003 VERSACOMP (4.2 ) COMPOSE2 (4.33) 04/22/02 (12:58) J:\VRS\DAT\00500\18.GML --- r500.sty --CTP READY-- v2.2 4/ POST DRAFTING SHAREHOLDER AGREEMENTS 18.01[1] [3] Employment Provisions in Shareholder Agreements [4] Non-Vested Stock [5] Forfeiture of Stock [6] Imputed Capital Contribution [7] Buy-Back in the Event of Death [8] Drafting With Section 83 in Mind [9] Application of Section 83 to S Corporations Special Considerations in Drafting S Corporation Shareholder Agreements [1] Buy-Sell Provisions Affecting S Corporation Status [2] Pricing Considerations [3] Redemptions Funded With Life Insurance Proceeds [4] Planning Opportunities and Pitfalls in Connection with Terminating Elections [5] Other Special Provisions For S Corporation Shareholder Agreements Form of Preliminary Letter Form of Shareholder Agreement [1] Introduction GENERAL CONSIDERATIONS One of the most frequent matters encountered by the tax practitioner is the preparation of Shareholder Agreements for closely-held C and S corporations. Although such agreements may seem routine, the various options selected by the practitioner in drafting a Shareholder Agreement can have a significant impact on the shareholders, both from a tax and non-tax standpoint. Because of the number of options available in drafting Shareholder Agreements and the complex tax (and non-tax issues) presented in the law, this article will highlight the primary tax issues that should be considered by the practitioner in drafting Shareholder Agreements for closely-held corporations, including, in particular, special provisions that should be considered when drafting a Shareholder Agreement for an S corporation and its shareholders. Appendix A to this article is a form letter that may be sent to clients in anticipation of meeting with them to discuss the drafting of a Shareholder Agreement, and Appendix B to this article sets forth a form Shareholder Agreement.

4 0004 VERSACOMP (4.2 ) COMPOSE2 (4.33) 04/22/02 (12:58) J:\VRS\DAT\00500\18.GML --- r500.sty --CTP READY-- v2.2 4/ POST [2] 60TH N.Y.U. INSTITUTE 18 4 [2] Definition of a Shareholder Agreement A Shareholder Agreement is a contract under which each shareholder agrees to offer his or her stock for sale to the corporation, the other shareholders, or both, on the occurrence of certain events, such as the shareholder s retirement, termination of employment, receipt of an outside offer to buy, death or disability. A Shareholder Agreement may also address a variety of issues relating to the operation and management of a corporation. A Shareholder Agreement is also commonly referred to as a Buy-Sell Agreement or a Stock Restriction Agreement. [3] Reasons for Shareholder Agreements A Shareholder Agreement can create a market for what is otherwise an unmarketable interest in a closely-held corporation. A Shareholder Agreement provides a means of determining a fair price for the shares of stock of a closely-held corporation in light of the goals sought to be achieved by the shareholders of the closely-held corporation. A Shareholder Agreement may be used to establish a control mechanism for the transfer of stock and to exclude or remove inactive or potentially dissident shareholders depending upon the circumstances and desires of the shareholders. A Shareholder Agreement may provide a means of transferring control of a closely-held corporation upon the death, disability or termination of employment (through retirement or otherwise) of a shareholder to other shareholders. A Shareholder Agreement may be used to reduce the financial pressure on a decedent s heirs to pay estate taxes and other expenses by providing for a mandatory purchase of a deceased shareholder s shares or by giving the estate (or the decedent s heirs) the option to sell such shares to the closely-held corporation. A detailed and well-drafted Shareholder Agreement will greatly reduce the potential for shareholder disputes resulting in litigation which would be both time consuming and costly to a corporation and its shareholders.

5 0005 VERSACOMP (4.2 ) COMPOSE2 (4.33) 04/22/02 (12:58) J:\VRS\DAT\00500\18.GML --- r500.sty --CTP READY-- v2.2 4/ POST DRAFTING SHAREHOLDER AGREEMENTS 18.01[5] A properly drafted Shareholder Agreement may prevent an S corporation from losing its eligibility to be an S corporation by restricting the shareholders from transferring their shares to an entity or other person that would be ineligible to hold shares of an S corporation. A Shareholder Agreement may set forth the mechanics for making certain elections which an S corporation and/or its shareholders can make with respect to allocations of income and loss when a shareholder terminates his or her entire interest in the S corporation or the corporation ceases to be an S corporation. A Shareholder Agreement may provide for the amount and timing of operating distributions. A Shareholder Agreement can assist in providing evidence of valuation for estate and gift tax purposes. [4] Documenting a Shareholder Agreement A Shareholder Agreement should, of course, be contained in a written document in the nature of a contract. The Shareholder Agreement s restrictions on stock transfer may also be documented in the corporate bylaws, charter, and on the stock certificates. U.C.C provides that restrictions on the transfer of stock must be evidenced on the security itself or they are not effective against subsequent transferees without actual notice. [5] Basic Forms of Shareholder Agreement There are three forms of corporate Shareholder Agreements: Redemption (or entity) Agreements, Cross-Purchase Agreements, and Hybrid Agreements. [a] Redemption Agreements A Redemption Agreement is a contract between each shareholder and the corporation, by which the corporation agrees to buy the offered stock. [b] Cross Purchase Agreements A Cross-Purchase Agreement is a contract between or among the shareholders, to which the corporation is not necessarily a party,

6 0006 VERSACOMP (4.2 ) COMPOSE2 (4.33) 04/22/02 (12:58) J:\VRS\DAT\00500\18.GML --- r500.sty --CTP READY-- v2.2 4/ POST 116 1/ TH N.Y.U. INSTITUTE 18 6 by which each shareholder agrees to buy all or part of the offered stock. [c] Hybrid Agreements A Hybrid Agreement is a contract among the corporation and the shareholders. In a Hybrid Agreement, a shareholder may offer his or her stock first to the corporation, and then to the other shareholders, or the shareholder may sell part of his or her stock to the corporation and part to the other shareholders. The corporation may be able to buy all or only part of the offered stock, with the shareholders buying the remaining portion of the offered stock INCOME TAX PLANNING FOR CROSS- PURCHASE SHAREHOLDER AGREEMENTS Cross-Purchase Agreements are often considered the simplest form of Shareholder Agreements because they raise the fewest income tax planning problems. A shareholder or his or her estate merely sells the shares to the other shareholders at the price and terms set by the agreement. [1] Impact on Selling Shareholder Corporate stock is typically a capital asset, so unless the shareholder is a dealer in stock, any gain on the sale is generally capital gain, regardless of the character of the corporation s underlying assets. Thus, a Cross-Purchase Agreement will be more advisable than a Redemption Agreement where a redemption may not qualify for sale or exchange treatment under section 302(a). 2 In addition to the tax rate preference applicable to net capital gains, 3 it is important that the gain under a cross purchase (or non-dividend equivalent redemption) be characterized as a sale or exchange, rather than as a dividend, since the seller will be allowed to recover 1 Hybrid Agreements obviously provide the most flexibility, and as such, are the most common type of Shareholder Agreement. The form Stock Restriction Agreement set forth in Appendix B is a Hybrid Agreement. 2 See 18.03[1], infra, for a discussion of the 302 redemption rules. 3 I.R.C. 1(h) generally sets forth a maximum capital gains rate of 20% as compared to the highest marginal income tax rate applicable to ordinary income under 1(i) of 39.1% for tax year 2001, 38.6% for tax years 2002 and 2003, 37.6% for tax years 2004 and 2005, and 35% for tax years 2006 and thereafter.

7 0007 VERSACOMP (4.2 ) COMPOSE2 (4.33) 04/22/02 (12:58) J:\VRS\DAT\00500\18.GML --- r500.sty --CTP READY-- v2.2 4/ POST 125 4/ DRAFTING SHAREHOLDER AGREEMENTS 18.02[1] basis without tax and if payments are to be made over a period of years, the seller will be allowed to use the installment sales method under section 453. An exception to capital gains treatment will apply if the corporation is a collapsible corporation within the meaning of section In such instance, the gain (but not loss) would be converted into ordinary income. Generally, a selling shareholder s basis in his or her stock will equal the amount paid for the shares plus the amount of cash and adjusted basis of property contributed to the corporation in exchange for stock or as a capital contribution. 5 In the case of the death of a shareholder, the shareholder s estate generally will receive a basis under section 1014 equal to the fair market value of the stock as of the date of the shareholder s death. 6 However, 4 I.R.C. 341(b) provides that the term collapsible corporation means a corporation formed or availed of principally for the manufacture, construction, or production of property, or for the purchase of property which (in the hands of the corporation) is property described in 341(b)(3) (generally, inventory, property held primarily for sale to customers in the ordinary course of trade or business or unrealized receivables), or for the holding of stock in a corporation so formed or availed of, with a view to: (1) the sale or exchange of stock by its shareholders (whether in liquidation or otherwise), or a distribution to its shareholders, before the realization by the corporation manufacturing, constructing, producing, or purchasing the property of two-thirds of the taxable income to be derived from such property; and (2) the realization by such shareholders of the gain attributable to such property. 5 See I.R.C. 1012, 351, 358 and Pursuant to applicable provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 ( TRA 2001 ), over the next 9 years, Federal Estate Tax Rates will be reduced and the applicable Exclusion Amount will be increased, until the year 2010, when both the Estate and Generation Skipping Transfer Taxes are repealed. Also in 2010, current rules under 1014, providing for a fair market value basis for property acquired from a decedent, also will be repealed and replaced with a significantly more complicated set of basis adjustment rules. Under these new rules, a receipt of property received upon a decedent s death will no longer be entitled to an automatic step-up in basis. Instead, recipients of a decedent s property at death will be entitled to an adjusted basis in such property equal to the lesser of (i) the decedent s adjusted basis in the property received or (ii) the fair market value of such property. In addition, recipients of property owned by the decedent at his or her death will be entitled to an aggregate basis increase of $1,300,000 (increased by certain carryovers and losses), plus an additional aggregate basis increase of $3,000,000 for qualified spousal property owned by the decedent at his or her death. To ensure compliance with the

8 0008 VERSACOMP (4.2 ) COMPOSE2 (4.33) 04/22/02 (12:58) J:\VRS\DAT\00500\18.GML --- r500.sty --CTP READY-- v2.2 4/ POST 127 6/ [1] 60TH N.Y.U. INSTITUTE 18 8 the estate of a deceased S shareholder will not receive a step-up in stock basis to date of death value to the extent of the shareholder s interest in unrealized receivables of the corporation. 7 This may have a dramatic impact on the tax cost of Shareholder Agreements to decedent s estates, especially in service based S corporations. [a] Adjustments to S Corporation Shareholder Basis For shareholders owning stock in an S corporation, adjustments to basis are made for the pass through of tax items in accordance with section If a shareholder disposes of stock during the taxable year, the basis adjustments with respect to such stock are effective immediately prior to the disposition. 8 Such adjustments will affect the computation of gain or loss on the sale of such shareholder s stock. The daily allocation rule of section 1377(a)(1) results in the selling shareholder of an S corporation being allocated an amount of the corporation s tax items even after the stock is sold. Absent an election under section 1377(a)(2) or under Regulations section (g)(2), the selling shareholder will be allocated his or her share of the S corporation s items of income, loss, deduction and credit for the tax year based on a per share, per day allocation. Under section 1377(a)(2), however, where a shareholder in an S corporation completely terminates his or her stock interest in the corporation, the corporation and all of the affected shareholders may elect hypothetically to close the taxable year of the corporation as of the date of sale in allocating tax items. The affected shareholders are the shareholders whose interest ends and all shareholders to whom such shareholder transferred shares during the taxable year. 9 If a shareholder s interest in an S corporation Congressional Budget Act of 1974, all these changes are inapplicable for taxable years beginning after December 31, Whether such new rules will actually go into effect in 2010 is not certain and how practitioners will plan for such uncertain changes is also problematic. 7 I.R.C. 1367(b)(4) provides that 691 (relating to income in respect of a decedent) will be applied with respect to any item of income of the S corporation in the same manner as if the decedent had held directly his pro rata share of such item. 8 Treas. Reg (d)(1). 9 I.R.C. 1377(a)(2)(B) and Treas. Reg (b)(2).

9 0009 VERSACOMP (4.2 ) COMPOSE2 (4.33) 04/22/02 (12:58) J:\VRS\DAT\00500\18.GML --- r500.sty --CTP READY-- v2.2 4/ POST / DRAFTING SHAREHOLDER AGREEMENTS 18.02[1] is redeemed by the S corporation, all the shareholders during the taxable year of the redemption are affected shareholders. If section 1377(a)(2) applies, the pro rata shares of the affected shareholders are determined as if the corporation s taxable year consisted of two taxable years, the first of which ends on the date as of the termination of the shareholder s interest. 10 If a shareholder disposes of 20% or more of the corporation s stock during a 30-day period, however, the corporation may elect to close the books hypothetically as of the date of disposition, for purposes of allocating items of income and loss. 11 Moreover, the regulations provide that a redemption treated as an exchange under section 302(a) or section 303(a) of 20% or more of the outstanding stock of the corporation from a shareholder in one or more transactions over a 30-day period during the S year will constitute a qualifying disposition for which the hypothetical closing of the books election may be made. 12 Because both the corporation and the affected shareholders must consent to a section 1377(a)(2) terminating election, and both the corporation and all shareholders must consent to a Regulations section (g) qualifying disposition election, the practitioner should carefully consider who has the power to act on behalf of the corporation (a majority of its board of directors, unless otherwise provided), and whether the determination by the corporation to make such an election should bind all shareholders to consent to such election. Depending upon the party represented, the election to close the books could be automatic, require all shareholders to consent upon the approval of the board of directors to make the election, or require all shareholders to consent upon the determination to make the election by a majority (or supermajority) of the 10 See 18.06[4], infra, for a discussion of the planning opportunities and pitfalls associated with making or not making the 1377(a)(2) election. 11 Treas. Reg (g)(2)(i)(A). 12 Treas. Reg (g)(2)(i)(B). Additionally, Treas. Reg (g)(2)(i)(C) provides that the issuance of an amount of stock equal to or greater than 25% of the previously outstanding stock to one or more new shareholders during any 30-day period constitutes a qualifying disposition for which an election to close the books may be made. In order to make the election to close the books upon a qualifying disposition, Treas. Reg (g)(2)(iii) provides that all shareholders who held stock in the S corporation during the tax year must consent to the election.

10 0010 VERSACOMP (4.2 ) COMPOSE2 (4.33) 04/22/02 (12:58) J:\VRS\DAT\00500\18.GML --- r500.sty --CTP READY-- v2.2 4/ POST / [1] 60TH N.Y.U. INSTITUTE shareholders. It is critical in situations where the agreement requires all shareholders to consent to an election if the board of directors, shareholders owning a majority of the outstanding stock or shareholders owning a supermajority of the outstanding stock determine that an election be made, that there be a power of attorney in the Shareholder Agreement appointing one or more persons to act on behalf of the shareholders to consent to such election. 13 [b] Transfers that Terminate Corporation s S Election If a sale of S corporation stock results in the termination of the corporation s S status, the taxable year of the termination is considered an S termination year as defined in section 1362(e)(4) and Regulations section (a). The S termination year is divided into two short taxable years, with Subchapter S governing the first short year (which ends on the day before the effective date of termination and is known as the S short year ) and with Subchapter C governing the balance of the year (the C short year ). The corporation generally allocates its items of income, loss, deduction and credit between the two short years based on the number of days in each year, on a per share, per day basis. Section 1362(e)(3), however, allows the corporation to elect to close its books on the day before the termination date, provided that all persons who own stock during the S short year and on the first day of the C short year consent to such election. Section 1362(e)(3)(B) and Regulations section (b)(1). Additionally, under section 1362(e)(6)(D), the books will close automatically if there is a sale or exchange of 50% or more of an S corporation s stock in an S termination year. [c] Passive Activity Loss Limitation Rules For dispositions of stock in an S corporation, Temporary Regulations section T(e)(3) requires that the resulting gain or loss be allocated among the various activities of the S corporation as if the entity had sold all of its interests (assets) in such activities, including activities conducted by ownership of a pass-through entity such as a partnership, as of a prescribed valuation date, for purposes of applying the passive activity loss limitation rules. 13 Paragraph 34 of the Form Stock Restriction Agreement in Appendix B sets forth an example of such a power of attorney.

11 0011 VERSACOMP (4.2 ) COMPOSE2 (4.33) 04/22/02 (12:58) J:\VRS\DAT\00500\18.GML --- r500.sty --CTP READY-- v2.2 4/ POST / DRAFTING SHAREHOLDER AGREEMENTS 18.02[2] [2] Impact On Cross-Purchase Buyers The buying shareholders will receive a cost basis in the shares of stock purchased, even if the purchase is funded with tax-free life insurance proceeds. To the extent that life insurance cannot be used to fully fund the purchase price, a disadvantage of the Cross- Purchase Agreement is that the purchasing shareholders will be acquiring the stock with after-tax dollars. [a] C Corporations This basis increase may actually be of only modest utility for shareholders in a C corporation, especially one which has significant earnings and profits. This is due to the fact that post-purchase distributions will frequently represent dividend income (instead of a tax-free return of capital) and their shares, including the newly purchased stock, will frequently be retained until their death, at which time the stock will receive a basis equal to date of death fair market value. 14 A debt financed acquisition of stock in a C corporation will generally generate investment interest expense subject to limitations on deductibility under section 163(d). [b] S Corporations A cross-purchase may be more desirable to the purchasing shareholders in an S corporation with a prior (and profitable) C corporation history since the cost basis for the acquired stock will not only reduce gain (or increase a loss) in the event of a subsequent sale, but will facilitate the tax-free receipt from the corporation s accumulated adjustment account (AAA) under section 1368(c)(1) or recovery of basis under section 1368(c)(3) for distributions made by the corporation. This is primarily attributable to the fact that a cross purchase will not result in a reduction in the S corporation s AAA. Having the purchasing shareholders obtain a cost basis in the acquired shares may also be important to absorb losses for those who are faced with a basis limitation problem under section 1366(d)(1)(A) or have already accumulated suspended losses from prior years due to insufficient stock (and debt) basis. 14 See Note 6, supra.

12 0012 VERSACOMP (4.2 ) COMPOSE2 (4.33) 04/22/02 (12:58) J:\VRS\DAT\00500\18.GML --- r500.sty --CTP READY-- v2.2 4/ POST / [3] 60TH N.Y.U. INSTITUTE Consideration must also be given to the possible application of the passive activity loss rules in section 469, as well as the at-risk limitations in section 465, in determining whether a cross-purchase is more favorable. Where the S corporation does not have earnings and profits from prior C years, the cross purchase arrangement will generally be more favorable since the shareholders will get an immediate basis increase in their stock and achieve only a single level of taxation on the use of corporate level profits to pay for the shares. Just like the selling shareholder, the purchasing shareholder will also be allocated a pro rata share of the S corporation s items of income, loss, deduction and credit for the tax year of the purchase. Absent an election under section 1377(a)(2) or Regulations section (g) to close the books of the S corporation, the allocation will be made on a per share, per day basis. 15 The use of a promissory note to acquire stock in an S corporation will be treated under Notice 89-35, 16 as a debt financed purchase. Consequently, the debt and related interest expense incurred in connection with the stock purchase can be allocated among all the assets of the corporation using any reasonable method (i.e., average monthly book value of company s assets). Accordingly, assuming the S corporation is engaged in a trade or business activity (as opposed to a rental activity) and the purchasing shareholder materially participates therein, the deductibility of the interest expense incurred by the shareholder on the debt financed stock purchase will not be subject to limitation under section 163(d) or 469. [3] Impact on Corporation There are few real tax effects on the corporation when a Cross- Purchase Agreement is executed. The shift in stock ownership does not affect earnings and profits or, as to an S corporation, either its earnings and profits or accumulated adjustments account. Unlike the rules governing purchases and redemptions of partnership interests, there is no mechanism for the buying shareholder to adjust his or her allocable portion of the 15 See 18.02[1][a], supra C.B. 675.

13 0013 VERSACOMP (4.2 ) COMPOSE2 (4.33) 04/22/02 (12:58) J:\VRS\DAT\00500\18.GML --- r500.sty --CTP READY-- v2.2 4/ POST / DRAFTING SHAREHOLDER AGREEMENTS 18.03[1] corporation s inside basis in its assets to correspond to such shareholder s outside basis in the corporation s stock. 17 Furthermore, unlike section 708 which provides for the termination of the partnership s taxable year in the event there is a sale or exchange of more than 50% of the interests (capital and profits) during a 12-month period, no similar rule applies to accelerate income (or the reporting of loss) by a C corporation or an S corporation. A Cross-Purchase Agreement also removes from direct consideration whether the corporation has adequate surplus with which to redeem the shares of the withdrawing shareholder under state law REDEMPTION AGREEMENTS Income tax planning for a Redemption Agreement is more complicated than that required for a Cross-Purchase Agreement. This is because the corporation is a necessary party to the agreement and often is the party who in fact purchases (redeems) the stock of the withdrawing shareholder. The rules of sections 302(b) and 303, by which sale or exchange treatment may be obtained, are complicated, and any Redemption Agreement must be carefully designed to assure that the redemption of a shareholder s stock will qualify for sale or exchange treatment. The practitioner must consider the probable situations under which a redemption is likely to occur, and whether sale or exchange treatment is likely to be available. If it is clear to the practitioner that sale or exchange treatment will not be available, a Cross-Purchase Agreement should be used. [1] Impact on Selling (Redeemed) Shareholder [a] Importance of Sale or Exchange Treatment In order for a selling shareholder to qualify for sale or exchange treatment, the redemption must meet the requirements of section 302(b). Qualifying for sale or exchange treatment in a redemption agreement is critical not only because of the ability to benefit from 17 See I.R.C. 754, 755, 743(b) and 1060(d).

14 0014 VERSACOMP (4.2 ) COMPOSE2 (4.33) 04/22/02 (12:58) J:\VRS\DAT\00500\18.GML --- r500.sty --CTP READY-- v2.2 4/ POST / [1] 60TH N.Y.U. INSTITUTE a shareholder s basis in his or her shares, but also because of the disparity in tax rates for net capital gains versus ordinary income The primary reason for avoiding dividend treatment is the ability to receive basis tax-free in a redemption treated as an exchange, in contrast to a dividend equivalent redemption whereby basis is not recovered until (and unless) the corporation has distributed all of its earnings and profits. Any residual unrecovered basis constitutes long-term capital loss, which by virtue of the limitation contained in section 1211(b), may be of limited utility. 2. If the purchase price is to be paid over a period of years, sale or exchange treatment will also qualify the sale for installment reporting under section 453 provided the stock is not publicly traded. [b] Dividend Treatment Dividend treatment can be disastrous especially with respect to post-mortem redemptions, since the estate of a deceased shareholder would normally recognize no taxable gain on a sale or exchange of stock due to the step-up basis received by an estate under section Example: Adam is a shareholder of the ABC Corporation, a C corporation. Pursuant to a Redemption Agreement, Adam s stock is to be redeemed after his death for $500,000 ($500 per share for his 1,000 shares). The corporation has substantial accumulated earnings and profits. If the redemption is taxed as a sale or exchange of the stock in accordance with section 302(a) or 303, the estate recognizes no gain because its income tax basis is $500 per share (the same as the sales price). If the redemption is taxed as a dividend under section 302(d), the estate has $500,000 of ordinary income, without regard to its basis and a corresponding $500,000 long-term capital loss. 19 [c] Sale or Exchange Treatment A redemption is treated as a sale or exchange of a shareholder s stock under section 302(b) if it: (1) is not essentially equivalent 18 See Note 3, supra. 19 See I.R.C. 1244(d)(4) (estate not eligible for 1244 loss treatment).

15 0015 VERSACOMP (4.2 ) COMPOSE2 (4.33) 04/22/02 (12:58) J:\VRS\DAT\00500\18.GML --- r500.sty --CTP READY-- v2.2 4/ POST / DRAFTING SHAREHOLDER AGREEMENTS 18.03[1] to a dividend; 20 (2) is substantially disproportionate; 21 (3) completely terminates the shareholder s interest in the corporation; 22 or (4) is of stock of a noncorporate shareholder in partial liquidation of the redeeming corporation. 23 Furthermore, the redemption cannot result in exchange treatment at the shareholder level if the corporation is collapsible. 24 Of these four categories, the substantially disproportionate and complete termination exceptions are the most useful for planning purposes, since they operate with mathematical precision. However, in proper circumstances, a redemption under a Shareholder Agreement might not be essentially equivalent to a dividend. Regulations section (b) provides that this determination is made on a case-by-case basis, looking at all of the relevant facts and circumstances. Thus, it is less useful for planning purposes than the substantially disproportionate redemption or the complete termination of interest categories. A redemption is substantially disproportionate for purposes of section 302(b)(2) if the shareholder s interest in outstanding common stock (both voting and non-voting) after the redemption is less than 80% of his or her interest before the redemption, and if, after the redemption, the shareholder owns less than 50% of the total combined voting power of all shares. Under section 302(b)(3), sale or exchange treatment applies if a shareholder terminates his or her entire proprietary interest in the corporation as a result of the redemption. The simplest example of a complete termination redemption is where a corporation is owned by two unrelated shareholders and the corporation redeems all of the stock of one shareholder for cash. Although many section 302(b)(3) redemptions will also qualify under section 302(b)(2), the potential scope of section 302(b)(3) is broader and could qualify a non-substantially disproportionate redemption of nonvoting stock or section 306 stock. 20 I.R.C. 302(b)(1). 21 I.R.C. 302(b)(2). 22 I.R.C. 302(b)(3). 23 I.R.C. 302(b)(4) and 302(e). 24 See Note 4, supra.

16 0016 VERSACOMP (4.2 ) COMPOSE2 (4.33) 04/22/02 (12:58) J:\VRS\DAT\00500\18.GML --- r500.sty --CTP READY-- v2.2 4/ POST / [1] 60TH N.Y.U. INSTITUTE [d] Attribution Rules Qualifying a redemption under either section 302(b)(2) or 302(b)(3), especially in the context of a family corporation, may be difficult because of the application of the constructive ownership rules of section 318. Stock is owned constructively if it is owned by certain family members, or entities in which the shareholder has an interest. Specifically, section 318(a)(1) provides that an individual be considered as owning the stock owned, directly or indirectly, by or for his spouse, children, grandchildren and parents. Section 318(a)(3) provides that stock owned, directly or indirectly, by partners, beneficiaries, or shareholders is attributed to their partnerships, estates, trusts or corporations, respectively. 25 Section 318(a)(2) generally provides that stock owned, directly or indirectly, by partnerships, estates, trusts and corporations is attributed to their owners, beneficiaries and stockholders, respectively. 26 Section 318(a)(4) provides that a person who has an option to acquire stock is deemed to own such stock. Section 318(a)(5)(B) provides that stock constructively owned by an individual by reason of the application of the family attribution rules will not be considered as owned by him for purposes of again applying the family attribution rules in order to make another 25 I.R.C. 318(a)(3)(A) provides that stock owned, directly or indirectly, by or for a partner or a beneficiary of an estate shall be considered as owned by the partnership or estate. Section 318(a)(3)(B) provides that stock owned, directly or indirectly, by or for a beneficiary of a trust will be considered as owned by the trust, unless such beneficiary s interest in the trust is a remote contingent interest. Section 318(a)(3)(C) provides that if 50% or more in value of the stock of the corporation is owned, directly or indirectly, by or for any person, such corporation shall be considered as owning the stock owned, directly or indirectly, by or for such person. 26 I.R.C. 318(a)(2)(A) provides that stock owned, directly or indirectly, by or for a partnership or a estate will be considered as owned proportionately by its partners or beneficiaries. Section 318(a)(2)(B) provides that stock owned, directly or indirectly, by or for a trust will be considered as owned by its beneficiaries in proportion to the actuarial interest of such beneficiaries in such trust. Section 318(a)(2)(C) provides that if 50% or more in value of the stock in a corporation is owned, directly or indirectly, by or for any person, such person shall be considered as owning the stock owned, directly or indirectly, by or for such corporation, in that proportion which the value of the stock which said person so owns bears to the value of all of the stock in such corporation.

17 0017 VERSACOMP (4.2 ) COMPOSE2 (4.33) 04/22/02 (12:58) J:\VRS\DAT\00500\18.GML --- r500.sty --CTP READY-- v2.2 4/ POST / DRAFTING SHAREHOLDER AGREEMENTS 18.03[1] the constructive owner of such stock. Thus, so-called double family attribution is prohibited under the operating rules of section 318. Likewise, section 318(a)(5)(C) provides that stock constructively owned by a partnership, estate, trust or corporation by reason of section 318(a)(3) (attribution to the entity), will not be considered as owned by it for purposes of applying section 318(a)(2) (attribution from the entity), in order to make another the constructive owner of such stock. Thus, in the typical family corporation, in which all stock is held by parents and their children, the redemption of all of the stock owned directly by any shareholder will be neither substantially disproportionate nor a complete termination of the shareholder s interest. Example: Father and Mother each own 1,000 shares of ABC Corporation stock; Son and Daughter each own 1,000 shares. Under a binding Redemption Agreement, the shares of any deceased shareholder must be redeemed by the corporation for $500 per share. Father dies in 1990, leaving all of his stock to Mother. His estate submits the stock to the corporation, which redeems it for $500,000 in cash. The $500,000 is treated as a non-exchange distribution under section 302(d), rather than a sale or exchange, because the estate is deemed to own 100% of the corporation s shares both before and after the redemption. Under the attribution rules, Mother is deemed to own the stock of her two children, as well as her own 1,000 shares. The estate is deemed to own the stock owned by its beneficiary, Mother, so before the redemption the estate is deemed to own 4,000 of the 4,000 outstanding shares, and after the redemption it is deemed to own 3,000 of the 3,000 outstanding shares. [e] Statutory Waiver of Family Attribution The distributee in a redemption can waive the family attribution rules under section 318(a)(1) in order to have a complete termination of interest under section 302(b)(3) if three requirements are met The Look Back. During the past 10 years, the distributee must not have transferred any stock to, or received any 27 I.R.C. 302(c)(2).

18 0018 VERSACOMP (4.2 ) COMPOSE2 (4.33) 04/22/02 (12:58) J:\VRS\DAT\00500\18.GML --- r500.sty --CTP READY-- v2.2 4/ POST / [1] 60TH N.Y.U. INSTITUTE stock from, someone from whom it would have been attributed to the distributee (other than stock received by bequest or inheritance), unless the distributee satisfies the IRS that the transfer did not have as one of its principal purposes the avoidance of federal income taxes. 28 The IRS will not issue an advance ruling on a complete termination if there were transfers within the past 10 years and the facts are not materially identical to one of these rulings The Look Forward. Immediately after the redemption, the distributee must have no interest in the corporation (other than as a creditor), including interests as an employee, officer, or director, and the distributee must not acquire such an interest for a period of 10 years following the date of the redemption Notification. The distributee must agree to notify the IRS of the acquisition of any prohibited interest in the corporation and to retain records of the transaction Retained Interest. The IRS takes an expansive view on whether a shareholder-distributee has retained any interest in the corporation. Clearly, any retained stock interest as well as payments for services rendered as a director, officer or employee is not permitted. Furthermore, rendering services as an unpaid consultant is also prohibited. 32 Moreover, the IRS ruled in Revenue Ruling , 33 that a former shareholder s right to have his counsel serve as a paid director of the corporation to protect his creditor interest on an installment redemption is not permitted despite the fact that the lawyer would be a minority director. 28 I.R.C. 302(c)(2)(B). For examples of transfers without a tax avoidance purpose, see Rev. Rul , C.B. 177; Rev. Rul , C.B. 179; Rev. Rul , C.B. 93; Rev. Rul , C.B. 91; Rev. Rul , C.B. 128; and Rev. Rul , CB Rev. Proc , I.R.B. 111, 3.01(19). 30 I.R.C. 302(c)(2)(A)(i). 31 I.R.C. 302(c)(2)(A)(iii). See Rev. Rul , C.B. 83 (prohibited interest acquired when shareholder was named custodian under the Uniform Transfer to Minors Act to hold stock for minor child). 32 Rev. Rul , C.B. 66; Rev. Rul , C.B C.B. 68.

19 0019 VERSACOMP (4.2 ) COMPOSE2 (4.33) 04/22/02 (12:58) J:\VRS\DAT\00500\18.GML --- r500.sty --CTP READY-- v2.2 4/ POST / DRAFTING SHAREHOLDER AGREEMENTS 18.03[1] Similarly, in Revenue Ruling , 34 the right to serve as a voting trustee to vote stock of the corporation was a prohibited retained interest where the beneficiaries of the trust were family members for purposes of section 318(a)(1) Retained Services. In Lynch v. Commissioner, 36 the Ninth Circuit held that post-redemption services either as an employee or independent contractor constituted a prohibited retained interest in the corporation within the meaning of section 302(c)(2)(A)(i). The Court held that the Tax Court s position of looking at all relevant facts and circumstances to determine if a taxpayer has retained managerial control or a financial stake in the corporation after the redemption is inconsistent with congressional intent to bring certainty into the area. 37 As an illustration of how narrow the court s focus in this area can be, in Seda v. Commissioner, 38 a father who had all of his stock redeemed terminated an employment relationship after being informed that his $1000 per month payments violated section 302(c)(2)(A)(i). The Tax Court held that such employment converted the redemption payments from capital gain into ordinary income. 39 [f] Entity Waiver of Family Attribution Rules Entities can waive family attribution, if both the entity and the related individual join in the waiver and agree not to acquire a prohibited interest, and if both agree to be jointly liable for any deficiency caused by the subsequent acquisition of a prohibited interest. Section 302(c)(2)(C). 34 Rev. Rul , C.B See Rev. Rul , C.B. 92 (a retained debt instrument may actually be a prohibited equity interest unless it is not subordinated to the other corporate debts and its payments do not depend on earnings) F.2d 1176 (9th Cir 1986), rev g 83 T.C See also Michael N. Cerone, 87 T.C. 1 (1986); Jack O. Chertkof, 649 F.2d 264 (4th Cir. 1981) (management contract with controlled affiliate disqualified family waiver) T.C. 484 (1984). 39 But see Estate of Lennard v. Commissioner, 61 T.C. 554 (1974), acq. in result only, C.B. 3, nonacq C.B.3.

20 0020 VERSACOMP (4.2 ) COMPOSE2 (4.33) 04/22/02 (12:58) J:\VRS\DAT\00500\18.GML --- r500.sty --CTP READY-- v2.2 4/ POST / [1] 60TH N.Y.U. INSTITUTE The entity waiver rule can be useful when an estate or trust beneficiary owns none of the redeeming corporation s stock personally, but is related to other shareholders. The entity waiver rule will not, however, be helpful if a beneficiary directly owns stock which he or she does not also have redeemed in the transaction. Example: Mother bequeathed her 1,000 shares of ABC Corporation stock to Father. Their children, Son and Daughter, each already own 1,000 shares of ABC Corporation stock and plan to run the business after Mother s death. Father owns none of the stock himself. After Mother s death, the corporation redeems her estate s 1,000 shares for $500,000. The estate can waive the attribution of Son s and Daughter s stock to Father under section 318(a)(1), from whom it would be attributed to the estate under section 318(a)(3), in order to have a complete termination of interest. Example: Assume the same facts as above, except that Father owns 1,000 shares of ABC Corporation stock and plans to continue to own these shares. Mother s estate cannot file a valid waiver of attribution, since the waiver will only sever family attribution and not entity attribution. Thus, while such a waiver could prevent the estate from being deemed to own the shares of Son and Daughter, it could not prevent the estate from being deemed to own Father s 1,000 shares. [g] Special Considerations for S Corporation Selling Shareholders The same rules governing shareholders in C corporations under section 302 (and 303) also apply to distributions in redemption of stock of an S corporation, including the stock attribution rules in section Characterization of a distribution as a redemption under section 302(a) or as a distribution under section 1368(a) may make little difference to the redeeming shareholder because of the distribution rules governing S corporations having no earnings and profits. Under section 1368(b)(1), distributions of cash or property made 40 I.R.C. 1371(a) (except as otherwise provided, Subchapter C rules applicable to Subchapter S except to extent inconsistent with Subchapter S) and 318(a)(5)(E) (S corporation treated as a partnership for entity attribution rules).

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